Thanks, But No Thanks

Reporter Nitasha Tiku covers technology, finance, green business, and social entrepreneurship for Inc. magazine and contributes to the staff?s daily links blog. Her work has appeared in New York magazine, The Villager, Chelsea Now, and on nymag.com. She lives in Brooklyn, New York.

In a tight credit market, businesses sometimes take funding wherever they can find it. But money that seems easy now may prove extremely difficult later. That's especially true with a fast-growing and risky new product for businesses, the merchant cash advance, or MCA.

A merchant cash advance -- also known as credit and receivables financing -- is essentially the business equivalent of a payday loan. A business owner is advanced a cash sum -- usually less than $150,000, often within a week and without the amount of paperwork required by banks. The merchant agrees to pay back the principal plus a fee, which is typically at least 25 percent of the total amount advanced but sometimes much more. The MCA provider collects the money by taking a portion of the business's credit card sales until the debt is paid.

Ideally, MCA providers offer companies with few financing options a quick, easy way to find funds in a cash-flow emergency. Some entrepreneurs like the arrangement because it allows them to repay less when sales are slow and more if revenue picks up. But it's a pricey form of financing. Most business owners complete repayment within six months, so paying a 25 percent fee is equivalent to taking out a loan with an annual interest rate of 50 percent or more.

A decade ago, there was one main MCA provider, AdvanceMe, then based in Kennesaw, Georgia, and it advanced less than $10 million a year. Now there are 50 such providers, says Marc Abbey, managing partner of First Annapolis, a consulting firm that has worked with MCA providers. Providers are now advancing about $700 million a year, and they have been marketing heavily, says Paul Martaus, president of Martaus & Associates, a research and consulting firm that focuses on the industry. AdvanceMe, now a wholly owned subsidiary of Capital Access Network, is still the biggest player in the industry and says it will probably advance about $1 billion to business owners over the next three years.

As the industry has grown, so has the controversy surrounding it. "The word unscrupulous comes up a lot in the business," Martaus says. Some providers advance as much money as possible, regardless of their customers' capacity for debt. Some have even changed their billing practices without notifying business owners. Last year, Karen Zebulon discovered that First Fund, the MCA provider she used for Gumbo, her Brooklyn clothing and gift store, had started taking money directly from her business checking account instead of deducting 25 percent of her credit card sales. Michael White, director of risk and recovery for First Fund, says the company's contract with Zebulon allowed such a change and that he reduced the withdrawals when Zebulon complained. But for Zebulon, it was too little, too late; she has since switched to AdvanceMe. "What First Fund did felt unethical," Zebulon says.

Traditional banks are regulated by several state and federal agencies, but MCA providers are not, partly because legally they are buying receivables, not making loans. That technicality also allows them to escape state usury laws; about a dozen states, including California and Texas, prohibit unlicensed lenders (and sometimes licensed ones) from charging businesses exorbitant interest rates.

Anat Levy, an attorney with Anat Levy & Associates in Beverly Hills, says usury laws should apply to MCA providers, too. In 2004, she filed a class action against Rewards Network (AMEX:IRN) on behalf of about 3,000 California restaurant owners. In court documents, the plaintiffs claimed the company broke California's usury law by charging effective interest rates as high as 419 percent. (Unlicensed lenders in the state aren't allowed to charge more than 10 percent.) Rewards Network, formerly known as both iDine and Transmedia, argued that its product isn't a loan. Indeed, the company says it's not even in the cash advance business, though it does provide funding to business owners, who repay it through receipts, with a fee that can reach 100 percent. But its process is more complicated than that of typical cash advance providers. Consumers register their credit cards with Rewards Network to get discounts at participating restaurants. Rewards Network advances cash to those restaurants, which pay it back by sending Rewards Network a portion -- typically 75 percent -- of the proceeds from meals bought by registered cardholders. In theory, if no such cardholders ever dined at the restaurant, the owner would never have to repay the advance, says Rewards Network CFO Chris Locke. He adds that Rewards Network brings new diners into participating restaurants. (In some cases restaurants don't take cash advances; they sign up because of the marketing advantages of the program, and they pay Rewards Network a smaller piece of each customer's bill.) The company contended in court that because it provided more than just money, its fees shouldn't be considered interest.

But a judge disagreed. Last July, U.S. District Court Judge Consuelo B. Marshall granted summary judgment to Levy and her clients. Judge Marshall pointed out that Rewards Network consistently used the term loan in previous court cases, when it sued business owners for repayment. The judge said the products were loans -- and usurious ones at that. Rewards Network settled the case in December 2006 without admitting wrongdoing. It paid the plaintiffs about $20 million and agreed not to collect about $35 million in payments from some of the plaintiffs.

Cases like that might give business owners pause. But many are drawn to merchant cash advances -- sometimes because they have no other options, sometimes because they need money quickly. Linda Coughlin, founder of Metro-Home, an $8 million New York City company that leases and furnishes apartments, then rents them to business executives for short- or long-term stays, got two $150,000 cash advances, one each in 2005 and 2006. In both cases, the money arrived less than a week after she submitted her application. Coughlin's business has no assets, and she didn't want to put up her home as collateral.

The fact that collateral isn't necessary is another important part of the MCA providers' pitch. Entrepreneurs sometimes risk losing their homes if they can't repay a bank loan, but they have no legal obligation to repay merchant cash advances if their companies fail, as long as they strictly follow the terms of the contract. They can't encourage customers to pay in cash, for example, and they cannot switch credit card processors (typically, the MCA provider gets paid directly by the processor, rather than by the merchant). "If Diane's Bistro goes out of business because Lauren's Bar & Grill opens up across the street, we have absolutely no recourse to Diane, none whatsoever -- as long as she follows the clearly defined covenants in our contracts," says Glenn Goldman, AdvanceMe's CEO.

If MCA providers suspect the contract has been broken, however, they sometimes aggressively pursue business owners for repayment. Richard Clark found that out the hard way when he closed Austin's, a Silicon Valley steakhouse, in July 2005. He had gotten $73,000 from AdvanceMe and promised to pay $109,500. When the restaurant closed, Clark still owed $46,000, and AdvanceMe sued, claiming that he had switched credit card processors. Clark maintains he did not; AdvanceMe dropped the suit when Levy, Clark's attorney, threatened to file a counterclaim and a class action. In an e-mailed response to questions, an AdvanceMe spokeswoman said the company weighed its potential legal costs against the amount Clark owed and decided not to pursue the suit but reserved the right to take action against him in the future.

For Clark, it was a bitter victory. "I was sweating bullets for payroll and taxes," he says. "I only wish I had closed the restaurant sooner." Indeed, as the economy falters, even Coughlin is rethinking the MCA. "It's not a good option for me anymore," she says. "We're not making as much money to cover those costs."